Notice of Accounts to Be Closed

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Ch. 5: Closing Process 1

Chapter 5
Closing Process

In this chapter you will see how accounting systems are organized to keep
results of different accounting periods separate from one another. The process
that produces financial statements relating to separate accounting periods is the
closing process.

The Accounting Process (so far)

In the first four chapters, we saw the goal of a company's financial
accounting system is to provide information about the company's resources and
where they came from. The information is provided in the form of financial
statements. To generate information for financial statements, accounting systems
are organized around the accounting equation:

Assets = Liabilities + Stockholders' Equity

The equality of the accounting equation is constantly maintained through
the debits equal credits process. In brief, in order to produce information for
financial statements, accounting systems:

Once the adjusted trial balance is prepared, it is possible to produce
reasonable financial statements from the adjusted trial balance data. The work
in Chapter 4 resulted in the Parks Computer Service Corporation's September
financial statements, presented again in Exhibits 5-1, 5-2, and 5-3.
2 Ch. 5: Closing Process

Exhibit 5-1
Parks Computer Service Corporation
Income Statement
for the Month Ended September 30

Revenues
Fees Revenue $3,300
Operating Expenses
Supplies Expense $170
Utilities Expense $60
Telephone Expense $45
Wages Expense $450
Rent Expense $325
Insurance Expense $120
Total Operating Expenses $1,170
Income Before Taxes $2,130
Income Taxes Expense $425
Net Income $1,705

From the Parks Computer Service Corporation's income statement we saw
management used the company's resources in September to generate $1,705 of
additional resources (net income). The income statement showed management
brought in resources of $3,300 (fees revenue) and used $1,595 of resources (total
operating expenses of $1,170 + income taxes expense of $425).

Exhibit 5-2
Parks Computer Service Corporation
Statement of Retained Earnings
for the Month Ended September 30

Retained Earnings, Sept. 1 $900
Net Income for September $1,705
Subtotal $2,605
Dividends $75
Retained Earnings, Sept. 30 $2,530

From the Parks Computer Service Corporation's statement of retained
earnings we saw of the $1,705 resources generated through management operations
in September (net income), $75 were distributed to the owner (dividends). By the
end of September, the company retained in the business $2,530 of the resources
generated through management operations in September and prior months.
Ch. 5: Closing Process 3

Exhibit 5-3
Parks Computer Service Corporation
Balance Sheet
September 30

Assets Liabilities & Stockholders' Equity
Cash $10,755 Liabilities
Accounts Receivable $1,210 Accounts Payable $240
Supplies $320 Unearned Fees Revenue $100
Prepaid Rent $650 Income Taxes Payable $425
Prepaid Insurance $360 Total Liabilities $765
Total Assets $13,295
Stockholders' Equity
Common Stock $10,000
Retained Earnings $2,530
Total Stockholders' Equity $12,530
Total Liabilities & Stockholders' Equity $13,295

The company's balance sheet showed on September 30 the company had resources
(assets) of $13,295. $765 of resources were borrowed (liabilities). $10,000 of
resources were invested by the owner (common stock). $2,530 of resources were
generated through management operations and retained in the company (retained
earnings).

Beginning a New Reporting Period

Closing fees revenue account Now that you are familiar with how the accounting
system works to provide reasonable information in the form of financial
statements, the next important question is: What happens when the company
continues to operate in the next reporting period? For example, if the Parks
Computer Service Corporation's September income statement showed management
generated $3,300 of fees revenue in September, what happens when management
services customers in October? Should the $3,300 fees revenue be carried over
into October?
Examine the company's general ledger fees revenue account presented below.
The $3,300 balance in the fees revenue account appeared on the company's
September 30 adjusted trial balance and on the September income statement.

Consider what would happen if the company provided $4,250 of additional
services to customers in October, prepared the proper journal entries, and posted
them to the general ledger. The October 31 general ledger fees revenue account
would appear as follows.
4 Ch. 5: Closing Process

Account Name: Fees Revenue Account Number: 411
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
5 Services provided J1 700 700
19 Services provided J1 1,400 2,100
29 Services provided J2 900 3,000
30 Services provided J3 300 3,300
Oct. 2 Services provided J1 600 3,900
9 Services provided J2 1,200 5,100
17 Services provided J2 900 6,000
26 Services provided J3 1,100 7,100
31 Services provided J4 450 7,550

If the Parks Computer Service Corporation were to prepare a trial balance
at the end of October, the fees revenue account balance would appear as a $7,550
credit balance. If this amount were to be used on the October income statement,
it would suggest management had brought in resources of $7,550 by providing
services to customers in October. A brief review of the general ledger fees
revenue account, however, clearly shows $7,550 of resources were not brought in
by management in October. In October, the company provided customer services of
$4,250 ($600 on October 2, $1,200 on the 9th, $900 on the 17th, $1,100 on the
26th, and $450 on the 31st). $3,300 of the services recorded as fees revenue had
been provided by management in September. Therefore, to report fees revenue of
$7,550 on the October income statement would be unreasonable. In order for the
more reasonable fees revenue amount of $4,250 to appear on the October income
statement, the $3,300 of September's fees revenue must be removed from the fees
revenue account. This is accomplished as part of the closing process. The
journal entry required to prevent September's $3,300 of fees revenue from
appearing in the October fees revenue account is as follows.

Posting
Date Description Ref. Debits Credits
Sept. 30 Fees Revenue 411 $3,300
Income Summary 399 $3,300
Close fees revenue

Several points should be noted in the above journal entry. First, the
entry was recorded at the end of September. Business is an ongoing process: once
one period is over, another begins immediately. In order to properly account for
this continuous process, once the financial statements for a period are prepared,
closing entries for the period can be immediately prepared to eliminate that
period’s effects from the general ledger accounts. As a result, in a new
reporting period the accounts will reflect only the activities of the new period.
A second point to note in the journal entry is the fees revenue account was
debited for $3,300. This debit is required because the fees revenue account had
a $3,300 credit balance on September 30 before the closing entry was made. To
eliminate or reduce a credit balance, a debit is required.
The third point to note is the credit to a new account, income summary.
Remember, net income is calculated as the difference between revenues and
expenses. One of the results of the closing process is net income briefly
appears in an account called income summary.
If the above entry to close the fees revenue account had been recorded in
the general journal and posted to the general ledger in September, the fees
revenue account at the end of October would have appeared as follows.
Ch. 5: Closing Process 5

Account Name: Fees Revenue Account Number: 411
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
5 Services provided J1 700 700
19 Services provided J1 1,400 2,100
29 Services provided J2 900 3,000
30 Services provided J3 300 3,300
30 Close fees revenue J6 3,300 0
Oct. 2 Services provided J1 600 600
9 Services provided J2 1,200 1,800
17 Services provided J2 900 2,700
26 Services provided J3 1,100 3,800
31 Services provided J4 450 4,250

As you can see in the general ledger, when the proper journal entry was
prepared and posted to close the fees revenue account at the end of September, by
the end of October the only amounts in the fees revenue account were those that
resulted from October transactions. The September 30 closing entry eliminated
all September fees revenue results. Thus, when the October income statement is
prepared, only the $4,250 of fees revenue reported in October will appear as
October fees revenue. In such a way, the closing process keeps the results of
different periods separate from one another: September’s fees revenue does not
appear on October’s income statement. As you probably suspect, at the end of
October the fees revenue account will again be closed so the results of October's
events will not appear as part of fees revenue reported in the November income
statement.
A final point to note about the September 30 closing of the fees revenue
account is total resources and total sources of resources did not change as a
result of the closing entry. Both the fees revenue account and the income
summary account are part of stockholders' equity. Thus, the closing entry
decreased and then increased sources of resources by the same dollar amount,
$3,300. This is reasonable because the company did not receive or use up any
resources simply by transferring dollar amounts from one stockholders' equity
account to another.

Sources of Sources of Sources of
Total = Borrowed + Owner Invested + Management Generated
Resources Resources Resources Resources
Assets = Liabilities + Stockholders' Equity
$13,295 = $765 + $10,000 + $2,530
+ - $3,300
+ + $3,300
$13,295 = $765 + $10,000 + $2,530

Closing supplies expense account Similar to the preceding discussion of fees
revenue, consider the supplies expense to be reported on the Parks Computer
Service Corporation’s October income statement. At the end of September, the
company’s supplies account and supplies expense account in the general ledger
were as follows.
6 Ch. 5: Closing Process

Account Name: Supplies Account Number: 115
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 140
3 Purchased on account J1 350 490
30 Used in September J3 170 320

Account Name: Supplies Expense Account Number: 511
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
30 Used in September J3 170 170

Suppose the Parks Computer Service Corporation did not purchase any additional
supplies in October and a review of supplies at the end of October revealed only
$200 of supplies were on hand. Since the general ledger supplies account reports
$320 of supplies, but only $200 were still on hand at the end of October, $120 of
supplies must have been used in October ($320 - $200 = $120). The adjusting
entry to properly record the October supplies expense is as follows.

Posting
Date Description Ref. Debits Credits
Oct. 31 Supplies Expense 511 120
Supplies 115 120
October supplies used

After the supplies adjusting entry was posted to the general ledger, the
supplies and supplies expense accounts appear as follows.

Account Name: Supplies Account Number: 115
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 140
3 Purchased on account J1 350 490
30 Used in September J3 170 320
Oct. 31 Used in October J4 120 200

Account Name: Supplies Expense Account Number: 511
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
30 Used in September J3 170 170
Oct. 31 Used in October J4 120 290

If the Parks Computer Service Corporation were to prepare a trial balance
at the end of October, the supplies account balance would appear as a $200 debit
balance and the supplies expense account would show as a $290 debit balance.
Remember, the October 31 examination of supplies revealed $200 of supplies
were on hand. Thus, the supplies account $200 debit balance in the general
ledger on October 31 is reasonable. It would be reasonable for this $200 to
appear as an asset on the company’s October 31 balance sheet.
However, what about the $290 debit balance in the supplies expense account
on October 31? The October 31 examination of supplies revealed $120 of supplies
had been used in October, not $290. Thus, October’s income statement should
report a supplies expense of $120, not $290. An examination of the supplies
expense account in the general ledger shows of the $290 balance in the account,
only $120 related to October, while the other $170 related to September’s
Ch. 5: Closing Process 7

operations. Clearly, reporting supplies expense of $290 on October’s income
statement would be unreasonable.
In order for the more reasonable supplies expense amount of $120 to appear
on the October income statement, the $170 of September's supplies expense must be
removed from the supplies expense account. This is accomplished as part of the
closing process. The journal entry required to prevent September's supplies
expense from appearing in the October supplies expense account is as follows.

Posting
Date Description Ref. Debits Credits
Sept. 30 Income Summary 399 $170
Supplies Expense 511 $170
Close supplies expense

Several points should be noted in the above journal entry. First, the
entry was recorded at the end of September. In order to properly account for the
continuous business process, once the financial statements for a period are
prepared, closing entries for the period can be immediately prepared to eliminate
that period’s effects from the general ledger accounts.
A second point to note in the journal entry is the supplies expense account
was credited for $170. This credit was required because the supplies expense
account had a $170 debit balance on September 30 before the entry was made. To
eliminate or reduce a debit balance, a credit is required.
The third point to note is the debit to the account, income summary.
Remember, net income is calculated as the difference between revenues and
expenses. One of the results of the closing process is net income briefly
appears in an account called income summary.
If the above entry to close the supplies expense account had been recorded
in the general journal and posted to the general ledger in September, the
supplies expense account at the end of October would have appeared as follows.

Account Name: Supplies Expense Account Number: 511
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
30 Used in September J3 170 170
30 Close supplies expense J6 170 0
Oct. 31 Used in October J4 120 120

As you can see in the general ledger, when the proper journal entry was
prepared and posted to close the supplies expense account at the end of
September, by the end of October the only amount in the supplies expense account
resulted from October transactions. The closing entry eliminated all September
supplies expense results. Thus, when the October income statement is prepared,
only the $120 of supplies used in October will appear as October supplies
expense. In such a way, the closing process keeps the results of different
periods separate from one another: September’s supplies expense does not appear
on October’s income statement. At the end of October the supplies expense
account will again be closed so the results of October events will not appear as
part of supplies expense reported in the November income statement.
As was the case with the closing of the fees revenue account, the closing
of the supplies expense account did not change total resources and total sources
of resources. Both the supplies expense account and the income summary account
are part of stockholders' equity. Thus, the closing entry decreased and then
increased sources of resources by the same dollar amount, $170. This is
reasonable because the company did not receive or use up any resources simply by
transferring dollar amounts from one stockholders' equity account to another.
8 Ch. 5: Closing Process

Closing other expense accounts Similar to the preceding discussion of closing
the supplies expense account at the end of a reporting period, all other expense
accounts will be closed. In order to keep the September expenses separate from
the October expenses, the Parks Computer Service Corporation would prepare the
following entries to close its other expense accounts at the end of September.
It is important to note that it is not necessary to close each expense account in
a separate entry. In most accounting systems, all expenses are closed in one
compound journal entry in which income summary is debited for the total of all
expenses while individual expense accounts are credited for their separate
amounts.

Posting
Date Description Ref. Debits Credits
Sept. 30 Income Summary 399 $60
Utilities Expense 513 $60
Close utilities expense

30 Income Summary 399 45
Telephone Expense 515 45
Close telephone expense

30 Income Summary 399 450
Wages Expense 517 450
Close wages expense

30 Income Summary 399 325
Rent Expense 519 325
Close rent expense

30 Income Summary 399 120
Insurance Expense 521 120
Close insurance expense

30 Income Summary 399 425
Income Taxes Expense 523 425
Close income taxes expense

Closing income summary account Once the fees revenue account and all expense
accounts are closed, their account balances are zero and the dollar amounts
previously in them have been transferred to the income summary account. The
Parks Computer Service Corporation’s income summary account would appear as
follows after the September revenue and expense accounts closing entries were
posted.
Ch. 5: Closing Process 9

Account Name: Income Summary Account Number: 399
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
30 Close fees revenue J6 3,300 3,300
30 Close supplies expense J6 170 3,130
30 Close utilities expense J6 60 3,070
30 Close telephone expense J6 45 3,025
30 Close wages expense J6 450 2,575
30 Close rent expense J6 325 2,250
30 Close insurance expense J6 120 2,130
30 Close taxes expense J6 425 1,705

After all revenue and expense accounts have been closed and the dollar
amounts posted to the income summary account, the balance in the income summary
account is the net income of the Parks Computer Service Corporation for
September. You can confirm this by comparing the $1,705 income summary balance
to the $1,705 net income shown on the income statement in Exhibit 5-1. At this
point it should be fairly clear how the income summary account got its name. The
income summary account summarizes the company's revenues and expenses for a given
time period. Since net income is calculated as the difference between revenues
and expenses, income summary is a logical name for the account summarizing
revenues and expenses.
As you remember, hopefully, a company's owners have a right to resources
generated by management (net income). Owners' rights are shown in stockholders'
equity accounts. The stockholders' equity account that reports net income kept
or retained by the company is retained earnings. The accounting process by which
net income is put into the retained earnings account is the closing of the income
summary account.
Consider the Parks Computer Service Corporation's income summary account
shown earlier. At the end of September, once the revenue and expense accounts
were closed into income summary, the income summary account had a credit balance
of $1,705, which represented the net income for September. At the end of
September, the income summary account would be closed and its credit balance
would be transferred into retained earnings through the following journal entry.

Posting
Date Description Ref. Debits Credits
Sept. 30 Income Summary 399 1,705
Retained Earnings 313 1,705
Close income summary

Once the income summary account is closed into retained earnings, the
income summary account balance is zero and the retained earnings account has been
increased by the net income reported in September. This can be seen by examining
the company's income summary account and retained earnings account shown as
follows.
10 Ch. 5: Closing Process

Account Name: Retained Earnings Account Number: 313
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 900
30 Close income summary J6 1,705 2,605

Compare the Parks Computer Service Corporation's retained earnings account
with its September statement of retained earnings shown in Exhibit 5-2 and
reproduced as Exhibit 5-4. Notice how the closing of the income summary account
into retained earnings increased the retained earnings account in the general
ledger by $1,705. This process had the same effect as adding net income to
retained earnings in the statement of retained earnings. You should see the
closing of income summary simply puts net income into retained earnings in the
same manner it was added to retained earnings in the statement of retained
earnings. Remember, owners' rights to resources increase as management generates
resources through operations. Owners' rights to management-generated resources
are reported in retained earnings.

Exhibit 5-4
Parks Computer Service Corporation
Statement of Retained Earnings
for the Month Ended September 30

Retained Earnings, Sept. 1 $900
Net Income for September $1,705
Subtotal $2,605
Dividends $75
Retained Earnings, Sept. 30 $2,530

As was the case with the closing of the fees revenue account and the
closing of the various expense accounts, the closing of the income summary
account did not change total resources and total sources of resources. Both the
income summary account and the retained earnings account are part of
stockholders' equity. Thus, the closing entry decreased and then increased
sources of resources by the same dollar amount, $1,705. Again, this is
reasonable because the company did not receive or use up any resources simply by
transferring dollar amounts from one stockholders' equity account to another.
Ch. 5: Closing Process 11

Close dividends account In a manner similar to the closing of income summary
into retained earnings, the dividends account is also closed into retained
earnings at the end of each reporting period. Remember dividends are
distributions of management-generated resources (net income) to owners.
Dividends reduce the company's resources (usually cash) and the owners' rights to
company resources. The closing of dividends would be recorded through the
following journal entry.

Posting
Date Description Ref. Debits Credits
Sept. 30 Retained Earnings 313 75
Dividends 315 75
Close dividends

Note in the above journal entry retained earnings was debited and dividends
was credited. Retained earnings was debited because retained earnings is reduced
through debits. Dividends was credited because it had a debit balance before it
was closed. You eliminate a debit balance with a credit.
The result of closing dividends into retained earnings can be seen by
viewing both accounts in the general ledger, shown as follows.

Account Name: Retained Earnings Account Number: 313
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 900
30 Close income summary J6 1,705 2,605
30 Close dividends J6 75 2,530

Account Name: Dividends Account Number: 315
Posting Balance
Date Item Ref. Debits Credits Debits Credits
Sept. 1 Balance 0
30 Cash dividend J2 75 75
30 Close dividends J6 75 0

Notice after the September dividends closing entry was posted to the
general ledger, the dividends account balance was zero. This account is now
ready to record dividends in October. Thus, if in October, management wants to
know the dollar amount of dividends declared by the board of directors in
October, they would simply have to look in the dividends account in October.
Since all September dividends were eliminated from the account at the end of
September, the only dollars in the dividends account in October must have come
from October activities. Once again, the closing process makes it easier and
faster to provide management with information.
Compare the Parks Computer Service Corporation's retained earnings general
ledger account with its September statement of retained earnings shown in Exhibit
5-2 and reproduced as Exhibit 5-4. Notice how the closing of the dividends
account into retained earnings decreased the retained earnings account in the
general ledger by $75. This process had the same effect as subtracting dividends
from retained earnings in the statement of retained earnings. You should see the
12 Ch. 5: Closing Process

closing of dividends simply takes the dividends amount from retained earnings in
the same manner it was subtracted from retained earnings in the statement of
retained earnings. Remember, owners' rights to management-generated resources
decrease as owners take resources out of the company. Owners' rights to
management-generated resources are reported in retained earnings.
As was the case with the closing of the fees revenue account, the various
expense accounts, and the income summary account, the closing of the dividends
account did not change total resources and total sources of resources. Both the
dividends account and the retained earnings account are part of stockholders'
equity. Thus, the closing entry decreased and then increased sources of
resources by the same dollar amount, $75. Again, this is reasonable because the
company did not receive or use up any resources simply by transferring dollar
amounts from one stockholders' equity account to another.

Closing Process Summarized

There are two primary reasons certain accounts are closed. First, in order
to easily keep the revenues, expenses, and dividends effects of one time period
separate from the effects of a second period, the first period’s effects are
eliminated from the revenues, expenses, and dividends accounts before the
beginning of the second period. As a result, the second period’s revenues,
expenses, and dividends accounts begin with zero balances. The second reason for
closing certain accounts is to reflect in stockholders’ equity accounts all
stockholders’ rights at the end of each period. Inasmuch as stockholders have
rights to net income, net income should be part of stockholders’ equity. The
closing process puts net income into retained earnings, which is a stockholders’
equity account. Since dividends reduce resources and stockholders’ equity, the
closing process reduces stockholders’ equity by closing dividends to retained
earnings. Thus, as a result of the closing process, retained earnings increases
with net income and decreases with dividends. This effect is exactly what is
reported in a statement of retained earnings, which you may want to quickly
review by referring to Exhibit 5-2 or Exhibit 5-4.
To accomplish the closing process, it is simply necessary to take the
following four steps.
Step 1: Close all revenue accounts to income summary. All the balances in
the revenue accounts can be quickly obtained from the adjusted
trial balance or the general ledger.
Step 2: Close all expense accounts to income summary. All the balances in
the expense accounts can be quickly obtained from the adjusted
trial balance or the general ledger. In actual business practice,
it is common to close all expense accounts in one compound journal
entry. It is not necessary to close each expense account in a
separate entry.
Step 3: Close the income summary account to retained earnings. The dollar
amount for this closing entry is a result of the closing entries
to income summary prepared in steps 1 and 2.
Step 4: Close the dividends account to retained earnings. The balance in
the dividends account can be quickly obtained from the adjusted
trial balance or the general ledger.
Ch. 5: Closing Process 13

Once the closing entries are prepared, they would be posted to the general
ledger and a post-closing trial balance would be prepared. The September 30
post-closing trial balance for the Parks Computer Service Corporation is shown in
Exhibit 5-5.

Exhibit 5-5
Parks Computer Service Corporation
Post-closing Trial Balance
September 30

Acct. No. Account Name Debits Credits
111 Cash $10,755
113 Accounts Receivable $1,210
115 Supplies $320
117 Prepaid Rent $650
119 Prepaid Insurance $360
211 Accounts Payable $240
213 Unearned Fees Revenue $100
215 Income Taxes Payable $425
311 Common Stock $10,000
313 Retained Earnings $2,530
315 Dividends $0
411 Fees Revenue $0
511 Supplies Expense $0
513 Utilities Expense $0
515 Telephone Expense $0
517 Wages Expense $0
519 Rent Expense $0
521 Insurance Expense $0
523 Income Taxes Expense $0
Totals $13,295 $13,295

Notice in Exhibit 5-5 that after the closing process: (1) all revenue,
expense, and dividends accounts have zero balances and (2) the balance in the
retained earnings account agrees with the retained earnings balance in the Parks
Computer Service Corporation’s statement of retained earnings for the month ended
September 30, as shown in Exhibits 5-2 and 5-4.

** You now have the background to do exercises 5.1, 5.2, 5.3, 5.4, and 5.5.

The Need for Closing Entries:
Periodic Reporting

The need to know about what management did with resources under its control
requires information about management’s action during a specific time period. It
is common to want to know about management’s action during the company's most
recent operating period, known as its fiscal year. You remember the income
statement is the report that provides such information. In many cases a
company's fiscal year is the same as the calendar year, but there are often
exceptions to this rule. For example, Microsoft Corporation's fiscal year covers
the months of July through June. Microsoft Corporation's income statement would
report on what management did with the company’s resources for the period July 1
through June 30. It is this need to know about management’s action during a
specific time period that created the need for the closing process. In order to
provide such information, the effects of management’s action in prior years must
be eliminated from income statement accounts (revenues and expenses) so only the
most recent year’s results will appear on the income statement. One of the
important parts of the closing process is to eliminate all prior year’s effects
from revenue and expense accounts. As a result, each year’s income statement
will report only the results of management action in that year.
14 Ch. 5: Closing Process

Consider Microsoft Corporation, whose income statements reported the
following: July 1, 2003 through June 30, 2004 net income, $8.2 billion; July 1,
2004 through June 30, 2005 net income, $12.3 billion; July 1, 2005 through June
30, 2006 net income, $12.6 billion. Microsoft Corporation’s income statements
suggest management used the resources under its control to generate $8.2 billion
additional resources in fiscal year ended June 30, 2004, $12.3 billion in its
fiscal year ended June 30, 2005, and $12.6 billion in fiscal year ended June 30,
2006. Suppose instead of reporting income for each year, Microsoft Corporation
did not close its revenues and expenses accounts but reported $33.1 billion net
income for the three fiscal years 2004 through 2006 ($8.2 + $12.3 + $12.6 =
$33.1). If a decision maker was given only the results of 2004 through 2006, how
could 2006’s net income be determined? How could 2005’s net income be
determined? Without additional information, it would be impossible for a
decision maker to determine 2006’s, 2005’s, or 2004’s net income. Inasmuch as
decision makers usually want to know the net income of individual years,
companies like Microsoft Corporation provide it by routinely closing all revenues
and expenses accounts at the end of each fiscal period.
Similar to the income statement, the statement of retained earnings reports
the results of the most recent year because that is the information decision
makers request. Decision makers want to know what the company did during the
most recent year with the resources generated by management during that year.
Did the company keep all the resources? Did the company give some of the
resources to owners (as dividends)? In order to provide such information, the
effects of the company’s action in prior years must be eliminated from
stockholders’ equity accounts (dividends) so only the most recent year’s results
will appear on the statement of retained earnings. One of the important parts of
the closing process is to eliminate all prior year’s effects from the dividends
account. As a result, each year’s statement of retained earnings will report
only the results of the company in that year.
Unlike the need to know about what management did with the company's
resources during a specific time period or what the company did with any
resources generated by management, the need to know about a company’s resources
and where they came from is related to a specific point in time. For example, it
is common to want to know about a company’s resources and sources of resources as
of the end of the company’s fiscal year. To provide information about resources
and sources of resources, companies prepare balance sheets. As you remember,
balance sheets report resources and their sources as of a specific date. For
example, Microsoft Corporation’s balance sheet would report resources and their
sources on June 30 each year.
It is important you understand why accounting systems require the closing
process. Although it is an extremely simple and routine process, it is essential
if accounting is to produce reports that keep the effects of different time
periods separate from one another. Without the closing process, the results of
many different time periods would be combined and it would be difficult for
anyone to determine what management or the company did in any one period.

The Complete Accounting Process

The goal of a company's financial accounting system is to provide
information about the company's resources and where they came from. The
information is provided in the form of financial statements. To generate
information for financial statements, accounting systems are organized around the
accounting equation:

Assets = Liabilities + Stockholders' Equity

The equality of the accounting equation is constantly maintained through
the debits equal credits process. In brief, in order to generate information for
financial statements, accounting systems:
Ch. 5: Closing Process 15

1. organize data to be reported by using a chart of accounts and a
general ledger.
2. analyze business events, or transactions, and convert them into debits
and credits through the preparation of journal entries. The journal
entries are recorded in the general journal.
3. post the journal entries to the general ledger.
4. verify the data in the general ledger accounts will result in a
balanced accounting equation through the preparation of a trial
balance.
5. review the data in the trial balance for reasonableness and prepare
adjusting entries to correct any unreasonable account balances.
6. post the adjusting entries to the general ledger.
7. verify the data in the general ledger accounts will result in a
balanced accounting equation through the preparation of an adjusted
trial balance.
8. prepare the financial statements: income statement, statement of
retained earnings, and balance sheet.
9. prepare journal entries to close revenue, expense, and dividends
accounts.
10. post the closing entries to the general ledger.
11. verify the data in the general ledger accounts will result in a
balanced accounting equation through the preparation of an post-
closing trial balance.

The accounting process is completed every period, with the result being
reasonable financial statements that report information about a company’s
resources, where the resources came from, what management did with the resources
during a given period, and what the company did with the resources management
generated during the given period.

** You now have the background to do problems 5.1 and 5.2.

Chapter 5 Critical Points

• Financial statements are prepared from the information in the
adjusted trial balance. The result is a set of financial statements
that can be relied upon as a reasonable representation of results of
management operations and company resources and their sources.
• The income statement and the statement of retained earnings report
company information related to a specific time period, usually one
year, called a fiscal year.
• The closing process keeps the income statement and statement of
retained earnings results of different time periods separate from one
another.
• At the end of each fiscal period, all revenue accounts are closed to
income summary.
• At the end of each fiscal period, all expense accounts are closed to
income summary.
• At the end of each fiscal period, the income summary account is
closed to retained earnings.
• At the end of each fiscal period, the dividends account is closed to
retained earnings.
• In addition to keeping the results of different time periods separate
from one another, by putting net income into retained earnings and
taking dividends out of retained earnings, the closing process
reflects all owners’ rights in stockholders’ equity at the end of the
fiscal period.

Chapter Five Questions
16 Ch. 5: Closing Process

1. What does it mean to close an account?

2. What are the two purposes of the closing process?

3. What is the name of the account to which revenues are closed?

4. Why are revenue accounts closed by debits?

5. What is the name of the account to which expenses are closed?

6. Why are expense accounts closed by credits?

7. Why does the name income summary seem appropriate for that account?

8. What does a credit balance in the income summary account before it is
closed represent?

9. What is the name of the account to which income summary is closed?

10. What is the name of the account to which dividends are closed?

11. What effect do closing entries have on total resources?

12. After the closing entries, what are the balances in revenue, expense, and
dividend accounts?

13. After the closing process, the balance in the retained earnings account
agrees with retained earnings reported on which two financial statements?
Ch. 5: Closing Process 17

Chapter Five Exercises

Exercise 5.1: Income Statement Without Closing Entries

The DiNatale Corporation's March 31 general ledger included the three
accounts shown below.

Fees Revenue Supplies Expense Salary Expense
3,000 (2/4) (2/15) 450 (2/28) 2,500
5,000 (2/12) (2/28) 300 (3/28) 2,500
2,000 (2/21) (3/13) 500 (3/31) 125
7,000 (2/27) (3/25) 200 5,125
4,000 (3/4) (3/31) 250
6,000 (3/9) 1,700
5,000 (3/16)
3,000 (3/24)
7,000 (3/31)
42,000

1. Determine the company's fees revenue for March.

2. Determine the company's supplies expense for March.

3. Determine the company's salary expense for March.

4. Determine the company's net income for March.

Exercise 5.2: Income Statement With Closing Entries

The Markvenas Corporation's May 31 general ledger included the three
accounts shown below.

Fees Revenue Supplies Expense Salary Expense
(4/30) 1900 400 (4/5) (4/12) 250 (4/30) 350 (4/28) 600 (4/30) 600
600 (4/14) (4/26) 100 (5/28) 600
100 (4/23) (5/11) 400 (5/31) 30
800 (4/30) (5/27) 200 630
500 (5/4) (5/31) 150
700 (5/10) 750
400 (5/17)
500 (5/24)
700 (5/31)
2,800

1. Determine the company's fees revenue for May.
18 Ch. 5: Closing Process

2. Determine the company's supplies expense for May.

3. Determine the company's salary expense for May.

4. Determine the company's net income for May.

Exercise 5.3: Closing Entries

The McKittrick Corporation's June 30 adjusted trial balance is shown
below.

Account Name Debits Credits
Cash $5,930
Accounts Receivable $6,800
Supplies $400
Prepaid Rent $600
Prepaid Insurance $750
Accounts Payable $590
Salaries Payable $70
Income Taxes Payable $500
Common Stock $8,000
Retained Earnings $4,700
Dividends $310
Fees Revenue $3,000
Salaries Expense $900
Rent Expense $300
Insurance Expense $250
Supplies Expense $120
Income Taxes Expense $500
Totals $16,860 $16,860

1. Prepare the McKittrick Corporation's closing entries required on June 30.

Posting
Date Description Ref. Debits Credits
June 30
Ch. 5: Closing Process 19

Posting
Date Description Ref. Debits Credits
June 30

2. Calculate the company's net income for June.

3. Calculate the company's retained earnings balance on June 30 after closing
entries are posted to the general ledger.

Exercise 5.4: Closing Entries

The Gravelle Corporation's February 28 general ledger included the six
accounts shown below.

Retained Earnings Dividends Income Summary
7,250 (2/1) (2/25) 300

Fees Revenue Supplies Expense Salary Expense
300 (2/3) (2/11) 150 (2/28) 1,400
600 (2/15) (2/24) 100
400 (2/23)
900 (2/27)
20 Ch. 5: Closing Process

1. Prepare the Gravelle Corporation's closing entries required on February 28.

Posting
Date Description Ref. Debits Credits
Feb. 28

2. Calculate the company's net income for February.

3. Calculate the company's retained earnings balance on February 28 after
closing entries are posted to the general ledger.

4. Calculate the company's dividends balance on February 28 after closing
entries are posted to the general ledger.

5. Calculate the company's fees revenue balance on February 28 after closing
entries are posted to the general ledger.

6. Calculate the company's salary expense balance on February 28 after closing
entries are posted to the general ledger.
Ch. 5: Closing Process 21

Exercise 5.5: Statement of Retained Earnings

The Ryan Corporation's March 31 general ledger included many accounts,
three of which are shown below.

Retained Earnings Dividends Income Summary
(3/31) 200 7,050 (3/1) (3/20) 200 200 (3/31) (3/31) 3,700 4,300 (3/31)
600 (3/31) (3/31) 600

1. Determine the company's net income for March.

2. Calculate the company's retained earnings balance on March 31.

3. Prepare the company's statement of retained earnings for the month ended
March 31.

Chapter Five Problem

Problem 5.1: Financial Statements, Closing Entries, Posting, and Post-closing
Trial Balance

1. Kristopher Lippe is the primary stockholder in the Lippe Equipment Repair
Service. The Lippe Equipment Repair Service's adjusted trial balance as of
May 31 is as follows.

Lippe Equipment Repair Service
Adjusted Trial Balance
May 31

Account Name Debits Credits
Cash $21,370
Accounts Receivable $7,540
Supplies $2,860
Prepaid Insurance $2,600
Prepaid Rent $1,820
Accounts Payable $6,110
Wages Payable $1,170
Income Taxes Payable $1,430
Unearned Fees $650
Common Stock $18,200
Retained Earnings $6,940
Dividends $600
22 Ch. 5: Closing Process

Account Name Debits Credits
Fees Revenue $9,880
Supplies Expense $780
Insurance Expense $390
Rent Expense $970
Wages Expense $4,290
Telephone Expense $120
Income Taxes Expense $1,040
Totals $44,380 $44,380

Based on the adjusted trial balance, determine the following:

A. Lippe Equipment Repair Service's net income for May $__________.

B. Lippe Equipment Repair Service's total assets on May 31 $__________.

C. Lippe Equipment Repair Service's total liabilities on May 31
$__________.

D. Lippe Equipment Repair Service's total stockholders' equity on May 31
$__________.

2. Prepare an income statement, statement of retained earnings, and a balance
sheet for Lippe Equipment Repair Service.

Lippe Equipment Repair Service
Income Statement
For the Month Ended May 31

Revenues
________________________ $__________

Operating Expenses
________________________ $__________
________________________ $__________
________________________ $__________
________________________ $__________
________________________ $__________
Total Operating Expenses $__________
Income Before Income Taxes $__________
Income Taxes Expense $__________
Net Income $_____2,290

Lippe Equipment Repair Service
Statement of Retained Earnings
For the Month Ended May 31

Retained Earnings, April 30 $_____6,940
Plus: Net Income $__________
Subtotal $__________
Less: Dividends $__________
Retained Earnings, May 31 $__________
Ch. 5: Closing Process 23

Lippe Equipment Repair Service
Balance Sheet
May 31

Assets
_____________________________________________ $__________
_____________________________________________ $__________
_____________________________________________ $__________
_____________________________________________ $__________
_____________________________________________ $__________
Total Assets $ 36,190

Liabilities & Stockholders' Equity
Liabilities
_____________________________________________ $__________
_____________________________________________ $__________
_____________________________________________ $__________
_____________________________________________ $__________
Total Liabilities $__________

Stockholders' Equity
_____________________________________________ $__________
_____________________________________________ $__________
Total Stockholders' Equity $__________
Total Liabilities and Stockholders' Equity $__________

3. Prepare the May 31 closing entries for Lippe Equipment Repair Service.

Date Description Debits Credits
May 31 ____________________ $__________
____________________ $__________
______________________________

31 ____________________ $__________
____________________ $__________
____________________ $__________
____________________ $__________
____________________ $__________
____________________ $__________
____________________ $__________
______________________________

31 ____________________ $__________
____________________ $__________
______________________________

4. Post the Lippe Equipment Repair Service's journal entries to its general
ledger. Calculate the ending balance for each general ledger account.

Cash Accounts Receivable Supplies
21,370 7,540 2,860
24 Ch. 5: Closing Process

Prepaid Insurance Prepaid Rent Accounts Payable
2,600 1,820 6,110

Wages Payable Income Taxes Payable Unearned Fees
1,170 1,430 650

Common Stock Retained Earnings Dividends
18,200 6,940 600

Income Summary Fees Revenue Supplies Expense
9,880 780

Insurance Expense Rent Expense Wages Expense
390 970 4,290

Telephone Expense Income Taxes Expense
120 1,040

5. Prepare the Lippe Equipment Repair Service's post-closing trial balance as of
May 31.

Lippe Equipment Repair Service
Post-closing Trial Balance
May 31

Account Name Debits Credits
Cash $_________
Accounts Receivable $ 7,540
Supplies $_________
Prepaid Insurance $_________
Prepaid Rent $_________
Accounts Payable $ 6,110
Wages Payable $_________
Income Taxes Payable $_________
Unearned Fees $_________
Common Stock $_________
Retained Earnings $_________
Dividends $_________
Ch. 5: Closing Process 25

Account Name Debits Credits
Fees Revenue $_________
Supplies Expense $_________
Insurance Expense $_________
Rent Expense $_________
Wages Expense $_________
Telephone Expense $ 0
Income Taxes Expense $_________
Totals $ 36,190 $_________

6. Based on your work, determine the following:

A. Lippe Equipment Repair Service's net income for May $__________.

B. Lippe Equipment Repair Service's total assets on May 31 $__________.

C. Lippe Equipment Repair Service's total liabilities on May 31
$__________.

D. Lippe Equipment Repair Service's total stockholders' equity on May 31
$__________.

E. The dollar amount of the Lippe Equipment Repair Service’s total
resources on May 31 was $__________.

F. The dollar amount of May 31 resources the Lippe Equipment Repair Service
obtained through borrowing was $__________.

G. The dollar amount of May 31 resources the Lippe Equipment Repair Service
obtained from owners was $__________.

H. The net dollar amount of resources the Lippe Equipment Repair Service
generated through management operations in May was $__________.

I. The dollar amount of May 31 resources the Lippe Equipment Repair Service
generated through management operations since the company was formed (not
just in May) and kept in the company was $__________.